Academic journal article Journal of Real Estate Literature

The Use of Options Pricing to Value the Bare Dominium of Property with Long Leases

Academic journal article Journal of Real Estate Literature

The Use of Options Pricing to Value the Bare Dominium of Property with Long Leases

Article excerpt

(ProQuest: ... denotes formulae omitted.)

Option pricing theory and the use of real options for the valuation of real estate have been used for quite some time. This has been said to provide better explanatory results than traditional property valuation techniques in that it valuations can be performed under uncertainty, conditions of limited information availability, or long-term lease structures. Option pricing as a derivative valuation technique has started to be tested on various real options in property decision-making, and is also now being applied to the valuation of certain aspects of property.

Current research on real estate options has focused on mortgages, development rights, and lease contracts (Oppenheimer, 2006), while option pricing theory has also been applied in investment options (Patel, Paxson, and Sing, 2005; Alexander and Chen, 2012). In this paper, I investigate the characteristic of property that the ownership of the fixed asset can be removed from the entitlement of use by way of a lease agreement. This characteristic influences the price at which a property can be sold, which is dependent on the terms of the lease contract. The use of option pricing is a suitable method in that it specifically considers the uncertainty that exists over the investment period. This provides the opportunity to quantify the risk that is associated with a particular property investment due to the varying lease periods that exist. In this regard, a distinction should be made between a lease and leasehold, where the former is usually of a shorter nature and mostly refers to the purchase of use for a specific period of time (Grenadier, 1995), while the latter usually refers to a longerterm contract where the lease holder takes possession of the land for a longer period of time and then develops it and sub-leases the improvements as per the definition of the lease. In this paper, I investigate the value of the remaining rights of an owner of a property after taking into consideration that the use rights had been removed by way of a leasehold for a period in time, considered to be the unforeseeable future.

The paper is considered to be relevant due to the criticism on existing valuation techniques that they do not have the capacity to take the risk of market changes into consideration, thereby making it very difficult, if not impossible, to quantify the remaining interest in a property after expiry of the lease holder's rights. Although many researchers have addressed option pricing techniques in real estate, this paper is different as i determine the value of the remaining rights in a property after removing the leaseholder's rights. No other previous research that was reviewed appears to address this specific aspect of property valuation.

The paper is structured as follows: in the literature review, i focus on the literature on property valuation techniques, the development and use of options pricing theory, and the use of options pricing in real estate. After the literature review, the analysis is provided. This firstly consists of a theoretical development and thereafter the details of four examples as a case study to show the application of the suggested method. The paper closes with a summary and conclusion.

Literature Review

property VALUATION TECHNIQUES

The differences between professional valuation and investment financial valuation is documented by Artemenkov, Mikerin, and Artemenkov (2008), whereby the former is stated to include illiquid assets such as real estate, and the latter more applicable to assets typically traded in public markets. The authors quote various authors of research on financial economics and valuation theory, and highlight the differences between various value concepts, such as price, value, individual worth, and market worth (e.g., IVSC, 2011). The differences highlighted are between the valuation of the different types of assets, which are indicated to be largely affected by economic and financial theory. …

Search by... Author
Show... All Results Primary Sources Peer-reviewed

Oops!

An unknown error has occurred. Please click the button below to reload the page. If the problem persists, please try again in a little while.